Speech Global Monetary Developments

Introduction

Over the past eight months, many central banks have reduced interest rates to unusually
low levels. Some have also undertaken unconventional measures to implement
monetary policy, such as:

giving commitments about the future path of interest rates;

greatly expanding their balance sheets; and

shifting the composition of their assets from securities that are short-term and
relatively risk-free to those that are longer-term and somewhat riskier.

Given the unprecedented nature of these measures, many people are asking what they
mean for the world economy, and particularly for inflation.

Debate about these issues will no doubt continue for a long time yet, and I certainly
don't pretend to have the answers. In my talk today I will set out what
various central banks have been doing, and offer a perspective on how these
actions could be interpreted.

Monetary Policy Implementation

Until recently, the majority of the world's central banks followed a fairly
standard model when it came to implementing monetary policy:

first, a monetary policy committee or board set a target for a short-term interest
rate, taking into account the central bank's objectives;

second, central banks then undertook operations in financial markets to adjust the
supply of funds in the market to a level consistent with the targeted short-term
interest rate; and

third, changes in short-term interest rates fed through to a wide range of other
interest rates in the economy.

An important channel through which this approach to monetary policy works is by influencing
the demand for credit. The supply of credit is assumed to adjust to demand,
which in a world of deregulated financial systems and stable, well functioning
markets, is a reasonable assumption.

When markets are disrupted, however, the normal transmission mechanism can break
down at several points:

first, the relationship between the amount of funds supplied through market
operations and the overnight interest rate can become unstable. For example,
if banks start to hoard liquidity, more funds need to be supplied to keep
the overnight rate at the target;

second, even if the target rate is achieved, the flow-through to other interest rates
in the economy may become impaired. If, for example, risk aversion in markets
increases, interest rates for term funds rise relative to the overnight rate,
and premiums for credit risk also rise. Reductions in the overnight rate targeted
by central banks, therefore, may not flow through to the same extent as usual
to interest rates charged on loans; and

third, if banks become capital constrained, their willingness and capacity to lend
at any interest rate will be diminished.

As you know, over the past year, many countries have found that the normal monetary
transmission mechanism has become less effective.

Interest Rates

As I noted, many central banks have responded to this by reducing official interest
rates to abnormally low levels, in some cases close to zero.

Most of this has happened since September last year. Up until then, monetary policy
settings around the globe had been following a relatively normal path, guided
mainly by inflationary pressures. Global monetary policy entered a tightening
phase around 2004 and the majority of central banks continued to tighten policy
into 2008. Of the 35 largest countries or monetary areas, 23 had higher interest
rates at September 2008 than at the start of the year, seven had unchanged
rates and five had lower rates (see Table 1). This is not surprising because
global inflationary pressures were still rising in the middle of 2008. Commodity
markets did not peak until July 2008, and indicators of pressure on global
capacity – such as prices charged on shipping contracts – were
at extreme levels.

Table 1: Changes in Monetary Policy

Change from 1 Jan
to 1 Sep 08
(basis points)

Change from 1 Sep
08 to present
(basis points)

Current level
(per cent)

Developed markets

United States

↓

225

↓

188

0.125

Euro area

↑

25

↓

325

1.00

Japan

0

↓

40

0.10

United Kingdom

↓

50

↓

450

0.50

Canada

↓

125

↓

275

0.25

Australia

↑

50

↓

425

3.00

Sweden

↑

50

↓

400

0.50

Switzerland

0

↓

250

0.25

Norway

↑

50

↓

425

1.50

Denmark

↑

35

↓

295

1.65

New Zealand

↓

25

↓

550

2.50

Emerging Asia

China

0

↓

216

5.31

South Korea

↑

25

↓

325

2.00

India

↑

125

↓

425

4.75

Taiwan

↑

25

↓

238

1.25

Indonesia

↑

100

↓

175

7.25

Thailand

↑

50

↓

250

1.25

Hong Kong

↓

225

↓

300

0.50

Malaysia

0

↓

150

2.00

Pakistan*

↑

300

↑

100

14.00

Philippines

↑

75

↓

150

4.50

Emerging Europe

Russia**

↑

100

↑

100

12.00

Turkey

↑

100

↓

750

9.25

Poland

↑

100

↓

225

3.75

Czech Republic

0

↓

200

1.50

Romania

↑

275

↓

75

9.50

Latin America

Brazil

↑

175

↓

275

10.25

Mexico

↑

75

↓

300

5.25

Chile

↑

175

↓

650

1.25

Colombia

↑

50

↓

400

6.00

Peru

↑

125

↓

225

4.00

Other

Saudi Arabia

0

↓

350

2.00

South Africa

↑

100

↓

350

8.50

Israel

0

↓

375

0.05

Iceland***

↑

175

↓

250

13.00

* After raising its policy rate by 200 basis points in November 2008,
Pakistan's central bank lowered its policy rate by 100 basis points
in April 2009.
** Russia's central bank increased its policy rate by a cumulative
200 basis points during November 2008 in moves aimed at stemming capital
outflows and mitigating the downward pressure on the ruble.
*** After
initially lowering rates by 350 basis points in mid October 2008,
the Icelandic central bank increased its policy rate by 600 basis
points two weeks later as part of the conditions of the IMF's rescue package.
Subsequent easings have amounted to 500 basis points.

Sources: Bloomberg; central banks

The unusual period of monetary policy began in September 2008, after the failure
of Lehman Brothers dramatically escalated the financial crisis. This in turn
led to a collapse of household and business confidence around the world. Official
interest rates have since been cut very sharply across virtually all countries
due to the highly synchronised nature of the current economic cycle. The average
reduction in interest rates has been 330 basis points in the developed economies
and about 300 basis points in emerging economies. Among the developed economies,
only four – Australia, New Zealand, Denmark and Norway – still
have official interest rates above 1 per cent. Official interest rates have
never been this low in the developed world in the 150-year period for which
we have data (Graph 1).

Graph 1

The reason why official interest rates have been reduced to such extreme levels is
that frictions in markets had made interest rates on loans to households and
businesses less responsive to cuts in official rates. In the case of the US,
for example, even though the Fed had reduced official rates by 325 basis
points by September 2008, the standard mortgage rate had hardly changed (Graph 2).
Bigger cuts in official rates were therefore needed in order to bring about
a given fall in interest rates on loans.

Graph 2

In assessing the level of global interest rates, it is important to look not just
at official rates, but at a broader spectrum of rates faced by borrowers. We
don't have data on housing rates going back 150 years, but it is
clear that they are not at the very low levels of official rates. In most countries,
including Australia, they are around 1½–2 percentage points below
their decade averages – that is, low, but not at extremes (Table 2).

Table 2: Mortgage Rates on New Housing Loans*

Predominant Mortgage Type

Current
Rate

10-year
Average
Rate

Deviation
from
Average

Australia

Standard variable

5.16

6.85

−1.70

United States

30-year fixed

4.63

6.42

−1.79

Canada

5-year fixed

3.89

5.65

−1.76

United Kingdom

Standard variable**

3.83

6.5

−2.67

United Kingdom

3-year fixed**

4.33

5.58

−1.25

New Zealand

2-year fixed

6.19

7.79

−1.60

Germany

Fixed (>10 years)

4.49

5.33

−0.84

Sweden

Variable

2.16

4.18

−2.02

Sources: Bloomberg; Thomson Reuters; national data
* Data: to April for Australia, US and Canada; to March for UK and
NZ; and to February for Germany.
** In the UK, variable rate and
1–5 year fixed-rate loans account for approximately the same proportion
of the market.

For corporate borrowers, interest rates are not unusually low. In fact, in most developed
economies, interest rates faced by corporations in capital markets are, if
anything, still a little above decade averages, due to the large increase in
risk premiums (Table 3).

Table 3: Non-financial Corporate Bond Yields*

Maturity

Current Rate

10-year
Average Rate

Deviation from
Average

Australia

1–5 years

7.29

6.62

0.67

United States

5–10 years

6.59

6.26

0.34

Canada

1–10 years

5.37

5.75

−0.38

United Kingdom

5–10 years

7.04

6.43

0.61

Euro area

7–10 years

6.00

5.50

0.50

New Zealand

10 year**

8.66

7.84

0.83

* Industrial corporates
** A-rated bonds

Sources: Bloomberg; Merrill Lynch

Other Monetary Measures

Let me now turn to the other unconventional measures central banks have undertaken.
These are often grouped in the popular press under the generic title of ‘quantitative
easing’ or ‘printing money’, but they really fall into three
distinct categories:

measures to add to banks' reserve balances;

measures to reduce the term structure of interest rates; and

measures to support specific credit markets and/or take credit risk onto central
bank balance sheets. The US Fed has coined the term ‘credit easing’ [2] to cover
such policies.

All these measures involve changes in either the composition or the size of central
bank balance sheets. While all are aimed at sustaining the flow of credit in
the economy, some do so by working on credit demand, while others aim to stimulate
the supply of credit. The measures are not mutually exclusive, but can be mixed
in different combinations to best suit the circumstances of the country. Indeed,
it can make sense, in terms of maximising their impact, for policies to combine
elements of each of the above measures.

Measures to increase bank reserves

Measures designed to increase the supply of bank reserves can, I think, be accurately
referred to as ‘quantitative easing’. They involve the central
bank increasing the size of its balance sheet by increasing its purchases of
securities from the market and crediting the payments to banks' reserve
balances at the central bank.

These measures differ from routine market operations both in their scale and their
intent. They involve operations on a much larger scale than normal. Some central
banks have expanded the supply of reserves by several percentage points of
GDP (Graph 3).

Graph 3

Perhaps more importantly, the objectives underpinning quantitative easing are different.
Whereas routine operations are working through interest rates to influence
the demand for credit, quantitative easing seeks to influence the supply of
credit. The aim is to provide more reserves than banks wish to hold, with the
intention that they will try to dispose of these excess reserves by increasing
their lending.

This type of activity is usually undertaken only when interest rates have fallen
to zero or near-zero levels. While, theoretically, a central bank could undertake
quantitative easing at any level of interest rates, in practice it is difficult
to do so, as large-scale provision of excess reserves forces the interest rate
to zero. The central bank could stop this from happening by paying a market-based
interest rate on reserve holdings, but this would undermine the purpose of
the exercise by reducing the incentive for banks to lend their reserves.

Measures to flatten the yield curve

As I noted earlier, monetary policy settings in most countries are normally defined
in terms of a target for a short-term interest rate. The precise relationship
between official interest rates and the interest rates faced by borrowers varies
from country to country. In some countries, such as Australia, where the bulk
of banks' loans to customers are at floating rates, the relationship
is usually relatively close. In countries where banks mainly lend to customers
at longer-term fixed rates, the relationship between official rates and loan
rates is more complex, and therefore more prone to being unsettled when market
conditions deteriorate. As such, loan rates in these countries can become quite
insensitive to changes in the short-term rate, reducing the effectiveness of
monetary policy.

Because of the limited flow-through from short rates to long rates, a number of central
banks have recently taken direct measures to reduce longer-term rates.

One way they have done this is by giving commitments to keep short-term rates low
for a long time. Central banks in the US, UK, Canada, New Zealand and Sweden
have done this. By signalling such a commitment, forward interest rate expectations
are lowered, resulting in lower longer-term yields. The success of this measure
in lowering term rates will naturally depend on how credible the commitments
are.

A second set of measures involves the central bank buying a large amount of long-term
assets. Such measures work mainly through a portfolio balance effect, increasing
demand for these securities above what it would otherwise have been, thereby
lowering their yields. There are, of course, also flow-on effects to other
asset prices.

Purchases of long-term securities can be undertaken in association with, or independently
of, quantitative easing. In the former case, the central bank would buy long-term
bonds and pay for them by adding to banks' reserves. In the latter, it
would buy long-term bonds but pay for them by selling some of its existing
holdings of short-term securities, or by issuing its own securities, thereby
leaving reserve balances unchanged. Purchases of long-term securities can also
contain an element of credit easing, if the securities being purchased carry
credit risk.

Credit easing

At their most basic, credit easing measures might involve simply expanding the range
of collateral that central banks will accept in their repo operations. Most
central banks in the world have done this over the past couple of years and
so can be thought of as having engaged in some limited form of credit easing.
But the term is normally understood to apply to more forceful measures, such
as:

providing long-term central bank funding to vehicles set up to acquire private
securities or loans;

These measures involve decisions about the allocation of credit between specific
institutions and sectors of the economy. This is usually a function of fiscal
policy, whereas monetary policy is normally general in its application. The
measures therefore start to blur the distinction between monetary and fiscal
policy.

The Effectiveness of Various Measures

As with normal monetary policy, the impact of these various unconventional measures
is likely to take quite some time to become apparent. This is particularly
the case for measures involving bank reserves.

Given the relatively limited time that most of these measures have been in place,
it is therefore premature at this stage to draw any firm conclusions about
their effectiveness. Also, as most of these measures were undertaken relatively
simultaneously, only their combined effects can be judged. So far, their main
impact seems to have been on market pricing, which is starting to return to
more normal levels.

One guide to the effectiveness of these measures may come from past episodes, such
as that in Japan in the early part of this decade. Of course, circumstances
differ greatly from country to country so there are limits on the extent to
which one country's past experiences are relevant to others.

The Japanese episode was very prolonged. The economy started to stagnate following
the collapse of property prices and the stock market in the late 1980s. The
interaction of macroeconomic weakness and instability in the banking system
exacerbated the downturn. Through the 1990s the Bank of Japan responded to
this by lowering interest rates but, by 1999, the policy rate had been reduced
to zero.

In 2001, the Bank of Japan switched from targeting an interest rate to an explicit
target for banks' reserve balances. The target was initially set at ¥5 trillion and then subsequently raised several
times to peak at ¥35 trillion (Graph 4).
Relative to GDP, this increase in reserves was not dissimilar to increases
recently experienced by other major central banks.

Graph 4

During the quantitative easing period, base money expanded rapidly due to the increase
in banks' deposits with the Bank of Japan (Graph 5). While one can
never know what the counterfactual would have been in the absence of this policy,
the evidence available indicates that the expansion in the money base did little
to boost broader money aggregates or bank lending. Instead, banks appear to
have hoarded the additional liquidity. Bank lending had been contracting since
the late 1990s and continued to do so through to 2006. Research conducted by
the Bank of Japan concluded that the ability of quantitative easing to impact
on aggregate demand and prices was limited.[3]

Graph 5

The Bank of Japan's experience also provides some evidence in relation to yield
curve measures. Its quantitative easing was implemented by buying long-term
government bonds and it also gave a commitment to maintain official interest
rates at zero for a long time. In effect, therefore, the quantitative easing
undertaken by the Bank of Japan was combined with measures to flatten the yield
curve. The evidence suggests that these measures were effective in lowering
the yield curve in Japan, particularly the medium-term point of the curve.

Conclusions

Let me conclude.

With central banks doing unconventional things, it is not surprising that there is
considerable debate about the effectiveness and consequences of the various
measures. On the one hand, some argue that the measures will be ineffective.
On the other side of the debate, others argue that they will eventually result
in higher inflation.

Those of the former view point to the experience of Japan over the past decade as
supporting their case. The conclusion they draw from that experience is that,
if the household and corporate sectors are seeking to consolidate their balance
sheets, and banks remain risk averse and capital constrained, simply adding
to banks' reserves at the central bank may not result in any generalised
expansion of money and credit.

The other side of the debate – that the measures will result in higher inflation
– implicitly assumes that the measures will be effective in stimulating
the economy, since money does not miraculously transform into inflation without
affecting economic and financial activity. Rather, their argument is that central
banks will be too slow to reverse the various measures.

As there are no technical factors that would prevent or slow the reversal of recent
measures – they can be reversed simultaneously or in any sequence –
the argument must rest on central banks making incorrect policy judgments.
This is always a possibility. But, the high state of awareness that currently
exists about the risk of being too slow to reverse recent exceptional measures
should limit the probability of such a mistake being made.

Endnotes

I would like to thank Chris Becker for his extensive assistance with this talk. [1]

See Bernanke, B (2009), ‘The Crisis and the Policy Response’, at the
Stamp Lecture, London School of Economics, London, 13 January. [2]